Whether they happen in June or later, rate cuts are now the order of the day for central banks. Sweden’s central bank cut rates for the first time in eight years this week; the European Central Bank has all but phoned in the June cut already. Swiss, Czech and Hungarian central banks have also cut – Europe is climbing down from the top of the mountain quicker than the Fed.  

Yesterday, the Bank of England left rates on hold yesterday with a 7-2 vote split on the Monetary Policy Committee. Inflation forecasts for the next 2-3 years were revised down to below the Bank’s 2% target. Cuts seem around the corner. 

The Bank of England has moved a lot closer to cutting rates, but it did not explicitly come down in favour of a cut in June. Forward guidance remained explicitly unchanged, even if there was quite a dovish spin elsewhere. There is more CPI inflation data in the meantime and the Bank does not want to tie its colours to the mast. But the downwards revisions for inflation over the next 2-3 years tells us a lot about where the BoE is expecting to go. Remember monetary policy is not about last month’s CPI report but the next 18 months at least. 

Governor Andrew Bailey said a June rate cut was ‘neither ruled out, nor fait accompli’. But he added that ‘it’s likely that we will need to cut bank rates over the coming quarters…possibly more so than currently priced into markets.”  

Bailey also spoke of the dynamic picture for central banks, saying there is no law that other central banks can move only after the US Fed. 

An expected rate cut by the ECB next month will confirm the divergence between Europe and the US. 

Some suggest that divergence will naturally have its limits. Others, such as the ECB’s Panetta, think that the Fed maintaining higher for longer rates strengthens the case for divergence.  

Jay Powell, the Fed chair, is not worried about divergence. The Fed sets rates for the US and does not look to other countries. For other nations, particularly emerging markets, it’s another matter.  

Will interest rate differentials affect the value of the euro or sterling? It’s hard to say. So far the repricing in rates expectations has been quite orderly, and quite sizable rate differentials only tend to lead to small moves in FX.  

A year ago markets priced EXB and Fed rates at about 2.75% by December 2024. Now they expect the ECB at 3.25% and the Fed at 5%. EURUSD has been a bit more volatile over the same time frame, but the absolute rate is barely changed from May last year – around 1.09/10 in May 2023 to around 1.07/08 today. It’s a bit different for the UK – a year ago we all thought Britain was facing a nightmare of inflation and higher-for-longer rates. But things have improved and UK rate expectations have since converged with the US. This shows that even calling it ‘divergence’ in policy outlooks is not as straightforward as it might seem. The worry for the BoE is that UK interest rates are being set in Washington not London; this ought to further galvanise support for a cut in June.  

But things can change. Next week’s US CPI inflation print is the next data point that poses a risk to the outlook for the Fed. 

Meanwhile the Bank of Japan is supposed to be going in the other direction by raising rates, but the market has sniffed out that it doesn’t really want to, resulting in pronounced yen weakness and wild gyrations in JPY crosses. Minutes from the last Bank of Japan meeting shows policymakers were really rather hawkish despite the rather more nuanced tone struck by governor Ueda. There has been a lot of jawboning this week and we could see another hike by July.

Neil Wilson

Chief Market Analyst at Finalto

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